New Canadian technical bill affects foreign affiliates.

• Author: Slaats, Sandra

Overview

On December 20, 2002, the Canadian Department of Finance finally released its long-awaited package of technical amendments. The draft legislation is designed to address a number of technical problems with the Income Tax Act that have accumulated during the last several years.

Many of the proposed amendments to the foreign affiliate rules address problems with the legislation that was introduced in 1995, when the rules were last significantly amended. Many of the amendments were expected, and implement changes of a relieving nature that were "promised" to taxpayers or their representatives in a series of so-called comfort letters. Those promises appear to have been kept, with one notable exception. Several changes recommended by groups such as Tax Executives Institute and the Joint Committee on Taxation of the Canadian Bar Association and the Canadian Institute of Chartered Accountants (the Joint Committee) have been included, but others have not.

Not all of the amendments are of a technical nature. In particular, two of the proposed changes relating to the disposition of foreign affiliates and property held by foreign affiliates were not expected, and may have a significant negative effect on transactions occurring after December 20, 2002.

This article focuses on the most significant changes made by the technical bill.

The General Section 95 Election

If a taxpayer wishes to apply a relieving change retroactively to a taxation year commencing after 1994, an election is available to do so (the general section 95 election or "general election"). The general election, however, entails the retroactive application of most of the foreign affiliate amendments contained in the technical bill, many of which deal with completely unrelated issues and are not of a relieving nature. This aspect of the technical bill was expected, and has been subject to much criticism. To date, however, Finance has not been persuaded to abandon this "all or nothing" approach.

The decision whether to make the election will involve a significant amount of analysis. Fortunately, the decision may not be required to be made for some time because of the need for consultation as well as the vagaries of the legislative process. The election is required to be filed by the due date for the taxpayer's return that includes the date when the legislation receives Royal Assent.

The review and processing of returns where the general election is made will also present a significant burden to the Canada Customs and Revenue Agency (CCRA). The legislation provides that the normal reassessment period limitations will not apply to the extent needed to give effect to the general election. The CCRA seems to have an unlimited period of time to review returns for the relevant period and make any adjustments within the scope of the general election, both positive and negative.

Reorganizations and Other Transactions

Two of the proposed amendments to the foreign affiliate rules are unexpected and can have a significant effect on common transactions. Fortunately, neither is part of the general election and, hence do not affect transactions occurring before the December 20, 2002, release date.

The first proposed change relates to certain transfers of shares of a foreign affiliate within a non-arm's-length group. In many cases in which a specific rollover provision (subsection 88(3) or paragraphs 95(2)(c), (d) or (e)) does not apply, the proposal (in proposed subsection 93(1.4) of the Act) would deem the shares transferred to be outside the definition of "excluded property." Consequently, any gain realized by an affiliate on the disposition of the shares (in excess of the amount eligible for a section 93 deemed dividend election) would create FAPI (foreign accrual property income), which is taxed immediately in the hands of the Canadian shareholder if the affiliate is a controlled foreign affiliate. If no consideration is paid for the shares, the vendor would be deemed to have received proceeds equal to the fair market value of the shares pursuant to section 69 of the Act.

The draft regulations also restrict the amount of surplus eligible for the section 93 deemed dividend in these circumstances. Draft regulation 5902(7) will prevent the taxpayer from accessing the surplus balances of affiliates owned by the affiliate that is the subject of the disposition.

According to the explanatory notes, the proposals are intended to prevent taxpayers from utilizing internal reorganizations to create additional surplus or an increase in the tax basis of shares in circumstances in which the shares transferred continue to be part of the group and continue to have surplus balances in respect of the taxpayer or a non-arm's-length party. Unfortunately, the proposals' consequences appear to be more severe than required to achieve those objectives.

There are many circumstances in which it is necessary or advisable to transfer the ownership of foreign affiliates within a related group. Such transactions occur for a variety of reasons unrelated to Canadian taxation. In many instances, shares of an affiliate are transferred without the issuance of shares to the vendor as consideration (a requirement for a paragraph 95(2)(c) rollover) since the receipt of shares may not be necessary for a tax-free transaction in the local jurisdiction. Now, many taxpayers have been forced to put such internal reorganizations on hold pending a determination of the effect of the new rules, and what is hoped will be a reconsideration of the draft legislation by the Department of Finance.

Transactions occurring after December 20, 2002, are grandfathered only from the application of the proposed rules if the disposition was required to be made under an agreement in writing existing at that date.

The second proposed change of significance also applies to dispositions occurring after December 20, 2002, but does not contain any grandfathering relief. The regulations currently contain a rule that prevents the recognition of surplus where capital property used in an active business is transferred to another foreign affiliate, and the transfer is eligible for rollover treatment under the local tax law. The draft legislation would significantly broaden this rule to extend its application to:

* all dispositions (other than certain rollover transactions), including dispositions to arm's length purchasers; and

* all excluded property (including shares of another foreign affiliate), not only capital property used in carrying on an active business.

The proposed rule would not apply if the gain or loss is included in an amount that was taxable under foreign law in computing the affiliate's earnings from an active business carried on by it (paragraph 5907(5.3)(a) of the Regulations).

There are a number of issues associated with the proposed rule, including its application to the sale of an affiliate by a holding company to an unrelated purchaser. Even if the sale of the affiliate is taxable in the holding company's jurisdiction (which is frequently not the case where tax planning has been undertaken) the gain would not be included in the earnings from an active business of the holding company carried on by it (as required by Regulation 5907(5.3)). As a result, no exempt or taxable surplus would be recognized in respect of the disposition. Any proceeds returned by the holding company to the Canadian shareholder in excess of the adjusted cost base of the shares would create a capital gain that could not be reduced to take into account foreign tax paid in respect of the gain.

Informal discussions with Finance officials suggest that this rule is likely to be modified to exempt dispositions of shares of another affiliate provided that the disposition is subject to tax in the holding company's jurisdiction. It is not clear, however, whether an exemption would be available if the holding company's jurisdiction imposes an income tax but provides a participation exemption on the disposition of shares of controlled foreign corporations. Although a gain reduction mechanism similar to our section 93 deemed dividend election would likely be acceptable, a complete exemption may not be. This will obviously be a significant issue in discussions with Finance.

The proposed rule is also problematic in its application to entities such as U.S. limited liability companies (LLCs) that have elected to be treated as disregarded entities for local tax purposes. No surplus may be recognized on the disposition of excluded property in the course of the LLC's business because the owner or owners of the LLC, not the LLC itself, are taxable in respect of the enterprise's earnings. This is of particular concern since the new...